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Fourth European Edition , Hillier et al.
Isadora Rosa Reyes
, Isadora Rosa Reyes- 547387
Chapter 12
What can a firm do with extra cash?
1. Pay out cash as a dividend
2. Invest it in a project, paying out the future cash flows as dividends
From the managers view the project should only be undertaken if its expected return is higher than
that of a financial asset with comparable risk.
The discount rate of the project should be the expected return on a financial asset of comparable
risk. The firm sees this the expected return as the cost of equity capital. Under CAPM it is said:
: ℜ=Rf + β∗( Rm−Rf )
Rf is risk free rate, (Rm-Rf) is called the expected excess market return or market risk premium. Rm
is return on market portfolio. Be aware that this Bèta is the equity Bèta.
Cov( Ri , Rm) σim
Bèta’s can be calculated by = 2
Var ( Rm) σm
Problems:
- Betas may vary over time
- The sample size may be inadequate
- Betas are influenced by changing financial leverage and business risk. This could be lessened
by adjusting for changes in business and financial risk.
To get a solution for the problems above, it is wise to look at the average beta estimates of several
comparable firms in the industry.
Real world Beta’s:
Usually they use 5 years data on the beta. Therefore, the practitioners know the accuracy of the
beta. However, firms may change their industry over time, so observations will be obsolete. People
frequently use the beta of the industry. The guideline for this is if you believe that your firms
operations are similar to the operations of the rest of the industry, then you should use the industry
beta simply to reduce the estimation error.
The regression analysis does not tell us where the beta comes from. It comes from
- The cyclical nature of revenues:
High-tech firms, retailers and automotive firms fluctuate with the business cycle. Firms in
industries as utilities, railroads, food & airlines are less dependent on the cycle.
- Operating leverage: Refers to firm costs of production. If we cannot estimate a project in
another way, we can examine the projects revenues and operating leverage. Projects whose
revenues appear strongly cyclical and whose operating leverage is high, have a high beta.
- Financial leverage: How much does the firm rely on debt. This is called the fixed costs of
finance. Business risk is the risk of a firm without financial leverage.
If we cannot estimate a projects beta in another way, we examine the projects revenues and the
operating leverage. Because start-up projects have little data, quantitative estimates of beta are not
feasible.
, Isadora Rosa Reyes- 547387
Financial leverage and beta
Operating leverage refers to the firms fixed costs of production. Financial leverage is how much a
firm relies on debt and a levered firm is a firm with some debt in its capital structure. Levered firms
make interest payments regardless of the sales, financial leverage refers to the firms fixed costs of
finance.
The beta of the assets of a levered firm is different from the beta of its equity. Asset beta is about the
beta of the assets of the firm. Asset beta is the same beta of the firm’s shares had the firm only been
E D
financed with equity : βasset= ∗βequity + ∗βdebt
D+ E D+ E
Beta equity is of a levered firm! If we make the common assumption that beta of debt is 0, we will
E
have: βasset= ∗βequity
D+ E
Because E/ (D+E) must be below 1, it follows that βasset < βequity. Equity beta will always be higher
than the asset beta with financial leverage (assuming that asset beta is positive).
D
This means that: βequity=βasset (1+ )
E
The risk of a project differs from that of the firm while going back to the all-equity assumption. Each
project should be paired with a financial asset of comparable risk. If a projects beta differs from that
of the firm, the project should be discounted at the rate that reflects project risk rather than firm
risk. Firms frequently speak of a corporate discount rate/ hurdle rate/ cut-off rate/ benchmark or
cost of capital. Unless all projects in the corporation are of the same risk, choosing the same discount
rate for all projects is incorrect.
If the proposed project has the same risk as the industry, the industry beta could be used.
Suppose a firm uses both debt and equity to finance its investments. If the firm pays Rd for its debt
financing and Re for its equity, what will the overall or average cost of capital be? The cost of debt is
the firms borrowing rate, Rd, which we ca often observe by looking at the yield to maturity on the
firms debt. If a firm uses both debt and equity, the cost of capital is a weighted average of the cost of
each funding source
E D
: ∗ℜ+ ∗Rd
D+ E D+ E
IF the firm has no issued debt, therefore it is an all-equity firm, its average cost of capital would be
equal to its cost of equity Re. If it would be an all-debt firm the average cost of capital would be Rd.
The after-tax cost of debt is: Rd∗(1−tc) Where Tc is the corporate tax rate.
E D
Average cost of capital : ∗ℜ+ ∗Rd∗(1−tc)
D+ E D+ E
Average cost of capital= weighted average cost of capital = Rwacc
The weights we use are market value weights.
Expected return and cost3 of capital are negatively related to liquidity. Although it is quite difficult to
lower the risk of a firm, it is much easier to increase the liquidity of the firms equity. A firm can lower
its cost of capital through liquidity enhancement.
, Isadora Rosa Reyes- 547387
What is liquidity?
We speak of the cost of buying and selling. Equities that are expensive to trade are considered less
liquid than those that trade cheaply. The cost of trade is brokerage fees, the bid-ask spread and
market impact costs.
- Brokerage fees: You must pay a broker to execute a trade.
- Bid-ask spread: quote of 100-100.07 this means that you can buy at 100.07 and sell at 100.
The spread of 0.07 is a cost to you because you are losing 0.07 per share.
- Market impact costs: the price drop associated with a large sale and the price rise associated
with a large purchase.
Trading costs vary across securities. Investors demand a high expected return as compensation when
investing in high-risk equities. Because the expected return to the investor is the cost of capital to the
firm, the cost of capital is positively related to beta. Investors demand a high expected return when
investing in equities with high trading costs, that is, with low liquidity.
Adverse selection: a counterparty will lose money on a trade if the trader has information that the
counterparty does not have. Traders in the market must protect themselves in some way. They will
reduce the price at which you are willing to buy or increase the price at which you are willing to sell.
The bid-ask spread will widen. The spread should be positively related to the ratio of informed to
uninformed traders. That is, informed traders would pick off the market and uninformed traders will
not. Informed traders raise the required return on equity, thereby increasing the cost of capital.
Firms should try to bring in more uninformed investors. Stock splits may be useful. Each investor
would be no better off than before. The share price will most likely fall. A round lot becomes more
affordable, thereby bringing more small and uninformed investors into the firm. The adverse
selection costs would be reduced, leading to lower bid-ask spreads. The share price might go up a bit
even. In almost all countries, there was a positive relationship between illiquidity (the inverse of
liquidity) and cost of capital – that is, illiquid stocks had a higher risk premium. Analysts frequently
state that they avoid following companies that release little information, pointing out that they are
more trouble than they are worth.
Firms nowadays raise capital, the costs of capital across countries have become an important issue
for financial managers who wish to minimize the cost of raising funds. This is possible in two ways:
1. Costs of going through an IPO
Underwriting fees, professional fees, listing fees and price discounts.
2. The ongoing costs of maintaining a public listing
Regulatory, corporate governance fees, annual listing fees and trading costs.
For a corporate manager the weighted average cost of capital is most important for capital
budgeting. The weighted average cost of capital is quite stable for European industries.
The most commonly used method is CAPM and beta. Historical returns on share prices are also used.
Regulators play an important role in the UK and France. The return investors received in the past is
the best predictor of the return investors will receive in the future. With such volatility in financial
markets, this is the most rational predictor.
Capital budgeting is forward looking because we must estimate future cash flows to value a project.
By contrast, performance measurement is backward looking. First is the return on assets (ROA)
Earnings after tax/ assets.
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